FIXING WALL STREET ´S PLUMBING WITH A NEW FED TOOL / THE WALL STREET JOURNAL

Heard on the Street

Fixing Wall Street's Plumbing With a New Fed Tool

By John Carney

Aug. 15, 2014 12:56 p.m. ET

Here's how Karl Marx might have put it: the first time as crisis, the second time as policy.

Back in 2008, the collapse of so-called repo markets—where cash-rich investors make overnight loans to financial firms and receive securities as collateral—was a signature event in the financial crisis. Now, the market is under pressure and contracting again—this time due to prudential policy rather than panic.

While that has caused discomfort among those who fear it might disrupt the flow of credit in the economy, many at the Federal Reserve would like to see repo shrink even further. That was the message coming out of a conference at the Federal Reserve Bank of New York this week.

This underscores the continued importance the Fed is rightly placing on financial-stability risks, even as it also tries to stimulate economic growth. This balancing act has grown even more important given the view of Chairwoman Janet Yellen and others that the Fed should look to macroprudential regulatory policies, and not interest rates, to control systemic risks.

The problem is that while regulation may seem more direct than the blunt instrument of rate moves, it often faces hurdles of its own. The repo market is an example. But the Fed's growing array of policy tools may provide a lever to spur further change.

Keep in mind, there is nothing inherently dangerous about repo. It is only problematic when firms rely too much on such short-term funding, which can make them vulnerable if cash investors get jittery and pull back. Bereft of funding, firms must sell assets, often at fire-sale prices. That can spark further panicked selling and trigger a crisis.

The Fed has had success reducing the role of the biggest banks in repo, mainly through capital and liquidity rules. But other market participants—namely mutual funds and broker-dealers—are still too reliant on the repo markets, in the Fed's view.

Speaking at the New York Fed conference, Boston Fed chief Eric Rosengren advocated higher capital requirements on broker-dealers and limits on the type of collateral money-market funds can accept.

The Fed, however, can't unilaterally impose such policies. Both broker-dealers and money-market funds are under the jurisdiction of the Securities and Exchange Commission. And it hasn't materially raised broker-dealer capital requirements or been willing to adopt strict rules on money-market funds.

The Fed may have an unexpected way around this. As it contemplates raising short-term interest rates, the Fed has looked to a variety of tools to deal with the impact on markets. One is a so-called reverse repo, where it would lend out securities in exchange for cash collateral.

Although designed as a monetary policy tool, it could potentially have use in the regulatory realm. A recent white paper from the Treasury Department's Office of Financial Regulation noted the reverse-repo program gives broker-dealers and money-market funds the ability to hold cash at the Fed directly.

The effect would be to reduce interconnections between banks, broker-dealers and money-market funds, simplifying the financial system and giving broader access to the safest asset class of all—the liabilities of the Federal Reserve. And it would shrink the repo market: The Fed could effectively crowd out broker-dealers, forcing them to fund portfolios from more stable sources.

For broker-dealers that would mean reduced profits, since such funding would be pricier. But that's a small price to pay for a less-fragile financial system.